Reducing the Chance of Pulling the Plug on Liquidity

The near collapse of the financial system that set off the global crisis was due in part to financial institutions suddenly lacking access to funding markets, and liquidity drying-up across securities markets.

Many financial institutions were unable to roll over or obtain short term funding without sustaining significant losses. This threatened to sink them.

Financial institutions did not factor in how their own responses to a liquidity shortfall could make the entire system shut down and less stable—that is, they underestimated their contribution to systemic liquidity risk in good times, and did not bear the cost of their actions on others in bad times.

It only takes a few institutions to pull the plug on a liquidity-filled bathtub before it runs dry, and the central bank needs to open the spigots again.

The key then is to make sure that firms have less incentive to pull the plug. This requires establishing the right incentives in the good times.

We argue that more needs to be done to introduce macroprudential policies–ones that take into account the big picture of the financial system as a whole.

In the latest Global Financial Stability Report, we have come up with a way to measure how much an individual financial institution contributes to system-wide liquidity risk.

This can be used to develop a macroprudential tool to capture the cost an institution imposes on the rest of the system. For instance, this can be achieved by requiring all financial firms that contribute to systemic liquidity risk to buy insurance proportionate to the expected contingent liquidity support they might need from central banks in times of systemic liquidity stress.

We propose three different approaches to measuring systemic liquidity risk:

a systemic liquidity risk index that captures breakdowns of various financial arbitrage relationships across securities and can be used to signal a tightening of market liquidity and funding liquidity conditions.

a systemic risk-adjusted liquidity model that can be used to calculate a time-varying, forward looking market-based measure of systemic liquidity risk, and an institution’s contribution to that risk; and.

a macro stress-testing model which gauges the effects of an adverse macroeconomic or financial environment on the solvency of institutions and in turn the impact failures may have on liquidity shortfalls of others.

Financial institutions have dealings with one another. Taking those interactions into account, we found that the probability that all institutions would have troubles meeting their cash flow needs was far higher during times of extreme market disruptions compared to if one were to simply add up each individual institution’s chances of liquidity problems.

Our research underscores that the whole is greater than the sum of its parts. The connections between asset and funding markets, and the relationships among financial institutions themselves, contribute to liquidity risk in the financial system in a way that cannot—and should not—be underestimated.

The next step is to test the models to see how they perform, and whether a capital surcharge or an insurance premium more cost effectively captures an institution’s contribution to systemic liquidity risk.

Ideally, our framework should be expanded to include all non-bank financial institutions that contribute to systemic liquidity risk. This can include special investment vehicles, money market mutual funds, hedge funds, finance companies and others. Much of this will depend on the structure of a financial system, and will vary from country to country.

Finally, we emphasize that a multipronged regulatory approach will have to be taken to address systemic liquidity risk. For instance, imposing add-on capital surcharges to control systemic solvency risk among global systemically important financial institutions, as is being currently considered under the G-20 reform agenda,may also help lower systemic liquidity risk.

The two risks are closely interrelated: if a regulator or supervisor imposes a capital surcharge for systemic solvency risk on financial institutions and that lessens the need to rely on systemic liquidity risk mitigation techniques, all the better.

But if the chosen measurement technique finds that there is still a residual contribution to systemic liquidity risk then an institution would then need to pay for it.

Finally, measures to make funding markets work better by strengthening the infrastructure underpinning them, for instance by having collateral behind repurchase agreements registered with central counterparties, would also help lower systemic liquidity risk.

A number of reforms have been put in place to address liquidity risk management at the individual firm level. The introduction of new quantitative liquidity standards under Basel III for commercial banks should help enhance the stability of the banking sector and indirectly help mitigate systemic liquidity risk.

But at their core Basel III reforms are microprudential—that is they are firm specific, and do not account for the myriad connections between institutions in the financial system, or its pro-cyclical tendencies—both which contribute to a buildup of systemic liquidity risk.